By: Bill Shaughnessy, Associate, Jones Walker LLP
The right to terminate without cause or the concept to “terminate for convenience” (originally utilized by the federal government during times of war1) has steadily evolved into a construction industry standard clause utilized by general contractors to terminate a subcontractor without having to establish the subcontractor as being in default and without the general contractor being liable for what would otherwise be a fundamental breach of contract damages, including consequential damages. The trade-off is that if a termination for convenience is used, the general contractor must generally reimburse the terminated subcontractor for its costs of performance to date, along with some markup and demobilization costs.
A “constructive” termination for convenience is based on a small addition to the subcontract termination clause that states that if the general contractor terminates the subcontractor for default (not for convenience), but the general contractor is later found guilty of a wrongful default termination, the termination is automatically converted to a termination for convenience and the general contractor retains the protections and limitations of liability of a termination for convenience. The ability of the Government in federal procurement to rely on the fallback of a constructive termination for convenience clause is fairly well-established. General contractors, on the other hand, should be aware that there are several cases that indicate that courts may rigorously review the conduct of the general contractor leading up to the termination and apply concepts of good faith and bad faith to deny the general contractor the opportunity to rely on the fallback of a constructive termination for convenience.
A popular variation of a constructive termination for convenience provision reads as follows:
Contractor shall have the right to terminate this agreement for its own convenience for any reason by giving notice of termination effective upon receipt thereof by subcontractor. Termination for default, if wrongfully made, shall be treated as a termination for convenience. Upon such termination, subcontractor shall be entitled to payment only as follows: (1) the actual cost of the work completed in conformity with this Agreement; plus, (2) such other costs actually incurred by subcontractor as are permitted by the prime contract and approved by Owner; (3) plus ten percent (10%) of the cost of the work referred to in subparagraph (1) above for overhead and profit…
This conversion language, from wrongful to convenience, protects the terminating party in the event the termination is deemed wrongful, thereby allowing the terminating party to avoid potential costs such as anticipatory profits and consequential damages that a disgruntled contractor could seek to recover in litigation. However, “wrongful” can have several meanings in the context of termination. For example, a “wrongful” termination could arise due to a contractor failing to comply with the notice provisions of the contract (i.e., failing to provide 48 hour right to cure a material breach). In that instance of a “wrongful” termination, courts have enforced the conversion provision of a contract, thereby limiting the terminating party from full exposure in litigation.2 On the other hand, a “wrongful” termination could be more severe, for instance in the case where a contractor acts in “bad faith” in executing the termination.
Detailed below are two examples of a general contractor not fully understanding the parameters of its conversion termination provision, and illustrates the risks associated with the clause being challenged by a resentful contractor in court. In these cases, the general contractor’s failure to act in good faith in terminating the subcontractor subjected the general contractor to liability for damages arising out of the termination, despite the conversion clause having been negotiated into the parties’ contract. Avoiding these mistakes made by the general contractors highlighted below could go a long way towards a general contractor avoiding an expensive court dispute on its next project.
Failing to Satisfy the Implied Obligation of Good Faith and Fair Dealing
In Questar Builders, Inc. v. CB Flooring, LLC, 410 Md. 241, 978 A.2d 651 (2009), Maryland’s highest appellate court held (unanimously (in a 7-0 decision)) the general contractor could not avoid breach of contract damages and hide behind a termination for convenience clause when the general contractor violated its obligation of good faith and fair dealing in terminating the subcontractor for default.
In that case, a flooring subcontractor (CB Flooring) filed suit against the general contractor (Questar) for wrongful termination. Questar alleged it had terminated CB Flooring for cause for material breach and reiterating that, even in the absence of a breach by CB Flooring, Questar enjoyed a right to terminate for convenience under the conversion provision of the subcontract. CB Flooring claimed that the termination for convenience clause did not apply because Questar acted in bad faith by invoking the clause after scheming to hire a replacement subcontractor in its place. The trial court rejected Questar’s contention that it enjoyed a right to terminate the subcontract for any reason noting that Questar’s “gut feeling” was not sufficient; however, the trial court did not render a conclusion of law as to when a termination for convenience clause would apply.
On appeal, the court held the terminating party was required to act reasonably in exercising the right to terminate for convenience:
Questar was permitted to terminate only if, in its discretion, it determined that continuing with the Subcontract would subject it potentially to a meaningful financial loss or some other difficulty in completing the project successfully… Questar was required to act reasonably in ensuring that the Subcontract did not become inconvenient, and it certainly was not permitted to create an inconvenience in order to terminate the Subcontract.
The court went on to hold that “under the covenant of good faith and fair dealing, a party exercising discretion must refrain from doing anything that will have the effect of frustrating the right of the other party to receive the fruits of the contract between them.” In other words, the right to terminate for convenience is not absolute under Maryland law and termination must be executed in compliance with the covenant of good faith and fair dealing, which Maryland courts have implied into every contract.
More recently in Peach State Roofing, Inc. v. Kirlin Builders, Inc., 2018 U.S. Dist. LEXIS 104662 (M.D. Ala. 2018), the U.S. District Court for the Middle District of Alabama, also applying Maryland law, held that a general contractor wrongfully terminated a subcontractor when it hindered the subcontractor from completing its scope of work and in withholding critical information and actively misleading the subcontractor into believing the government had accepted the subcontractor’s work.
There, the general contractor argued it had properly exercised its right to terminate, both for the subcontractor’s alleged default and under the termination for convenience clause in the subcontract. And the general contractor argued at the very least, even if the termination was determined to be wrongful, it could fall back on the conversion clause. However, the District Court disagreed finding the general contractor did not deal with the subcontractor in good faith. Due to the general contractor’s own conduct leading up to termination, the District Court held the general contractor was unable to hide behind the termination for convenience clause in the subcontract and thereby breached the agreement by wrongfully terminating the subcontractor. Similar to the facts in Questar, the general contractor had been in frequent and direct communications with a replacement subcontractor while the original subcontractor was still under contract.
While not all states have directly addressed the issue of a conversion clause in the context of the implied duty of good faith and fair dealing, it is very possible that the duty of good faith would be implied into the application of a termination for convenience clause of a construction contract in states such as Iowa3, Minnesota4, North Dakota5, South Carolina6 and New Jersey.7
This of course raises the question of what constitutes a breach of the implied duty of good faith and fair dealing. Generally, this implied duty requires parties cooperate with one another so that they each obtain the full benefit of their contracted bargain. However, this is a very factual determination that would be dependent on the circumstances surrounding termination and would vary from state to state. Therefore, contractors and subcontractors must pay close attention to the inclusion of such termination for convenience clauses in contracts. If issuing the termination, contractors should be advised to (i) follow the notice provisions leading up to termination, and (ii) ensure it is acting in good faith with the contractor leading up to and in executing the termination. After the termination has taken place, if the termination is wrongful, there may be serious and expensive legal consequences. Depending on which side of the table you are on, terminating or terminated, a further discussion with a local attorney in the applicable jurisdiction may be necessary in order to protect your respective interests going forward.
1“The termination for convenience clause developed in Civil War shipbuilding contracts and was further refined in U.S. government munitions contracts in World Wars I and II. The theory was that the government needed broad discretion to terminate its wartime contracts at the end of hostilities.” Wrongful Termination for Convenience Results in a Finding of Breach of Contract Against the Government. July 28, 2010, Thomas M Brownell; Gregory R. Hallmark; https://www.hklaw.com/publications/wrongful-termination-for-convenience-results-in-a-finding-of-breach-of-contract-against-the-government-07-28-2010/.
2See e.g. Semac Electric Company v. Skanska USA Building, Inc., 2017 WL 4508507 (CT. Super. Ct. Aug. 23, 2017) (unpublished opinion) (Subcontract containing a conversion termination for convenience clause, the general contractor successfully relied on conversion language of contract to recover overpayments to the subcontractor, despite the court’s finding that the general contractor had wrongfully terminated subcontract by failing to comply with notice and cure provisions of subcontract prior to termination); R&J Construction Corporation v E.W. Howell Co., Inc., 2008 N.Y. Misc. LEXIS 9430 (upholding and enforcing conversion clause in construction contract).
3Am. Tower, L.P. v. Local TV Iowa, L.L.C., 809 N.W.2d 546 (“[i]t is generally recognized that there is an implied covenant of good faith and fair dealing in a contract.”).
4In Re Hennepin Cty. 1986 Recycling Bond Litig., 540 N.W.2d 494 (1995) (Under Minnesota law, every contract includes an implied covenant of good faith and fair dealing requiring that one party not “unjustifiably hinder” the other party’s performance of the contract.).
5Cavendish Farms Inc. v. Mathiason Farms, Inc., 210 ND 236, 792 N.W.2d 500 (failure to perform under the contracts in good faith constitutes a breach of the terms of the contracts).
6Adams v. G.J. Creel and Sons, Inc., 320 S.C. 274, 465 S.E.2d 84 (1995); see also U.S. for Use and Benefit of Williams Elec. Co v. Metric Constructors, Inc., 325 S.C. 129, 480 S.E.2d 447 (1997) (applying duty of good faith and fair dealing to construction contract).
7A termination for convenience is valid absent a showing of bad faith. See Capital Safety, Inc. v. N.J. Div. of Bldgs. & Constr., 369 N.J. Super. 295, 300-01 (App. Div. 2004) (A party “breaches the duty of good faith and fair dealing if that party exercises its discretionary authority arbitrarily, unreasonably, or capriciously, with the objective of preventing the other party from receiving its reasonably expected fruits under the contract.”).
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